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By Ruth Saldanha | 03-05-2019

Small caps come with large discounts

Gold-rated fund manager Teresa Lee looks for good businesses, with strong management teams, that are trading at a discount

Note: This video is part of Morningstar Canada's Women in Investing Special Report

Ruth Saldanha: With most experts agreeing that a Canadian recession is unlikely in the immediate future, where should you invest? Do valuations of higher-risk small-cap stocks make sense right now? And how should you play this space in 2019? Teresa Lee, Co-Chief Investment Officer of Sionna Investment Managers and the Manager of the Gold-rated Sionna Canadian Small Cap Equity Fund, is here with us today to discuss this. Teresa, thank you so much for joining us.

Teresa Lee: Thank you for having me.

Saldanha: After the volatility in late 2018 the markets have seen a bit of a rally in the early parts of 2019. How do you expect the markets to play out going ahead?

Lee: Well, after the significant decline in the fourth quarter of 2018 we've seen valuations come down significantly. When we look back 12 to 18 months ago, valuations in the large-cap space were closer to 20 times price to earnings multiples. Currently, they are closer to 14 times price to earnings. When we look at small-caps relative to large-caps, they are actually even cheaper. Small-caps historically have traded at a discount of 20% to 25% relative to large-caps. Currently, we are seeing discounts closer to 50%. So, we are seeing a significant valuation discount in the small-cap market and an already lower price to earnings market overall.

So, when we look forward to 2019, we expect that the market should continue its rally. However, we don't know how investors will react and whether they will react in a rational manner. We hope that they will react in a rational manner, but you never know how investors behave.

Saldanha: So, how are you playing the markets right now? What's your strategy?

Lee: Our strategy is to continue to do what we've always done in the past, which is to look for good businesses that are trading at a discount to intrinsic value. When the market is indiscriminately selling off names regardless of fundamentals, we are finding really interesting opportunities here to pick up quality businesses that are trading at discounts.

Saldanha: What are some of the factors that you look for in the companies that you select?

Lee: Well, in the small-cap space what we really want are just good businesses with strong management teams that are trading at a discount. So, a good business would be companies with good long-term returns and a number one or number two position leaders in their business. A good management team is a management team with a strong track record that owns a significant amount of the shares, so they are well aligned with us as investors and we want to buy those companies when they have a hiccup in the business, and we are able to pick those up at a discount.

Saldanha: Finally, what are some names you like right now, especially to hold for the long-term?

Lee: We really like – one of the highest-quality names we own in the portfolio is Winpak. Winpak is a packaging company that do a lot of food packaging. Food packaging is a resilient and growing business because of the trend towards convenience packaging. So, Winpak will make things like the little coffee creamers that you would drink a coffee in or the convenient-sized pringles packs. And with that trend towards convenience, we think there's significant organic growth in the business and they have continued to grow their business quite nicely internally just through investing in the business themselves and building new capacity.

Saldanha: Thank you so much for joining us today, Teresa.

Lee: Thank you for having me.

Saldanha: In early May, the Sionna Capital Small Cap Fund will be merging with another Sionna fund, the also Gold-rated Sionna Opportunities Fund. The small-cap strategy will continue to exist and be available through either a pooled fund vehicle or in a separately managed account for larger institutional clients.

For Morningstar, I'm Ruth Saldanha.

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